Crypto Trading 101: Cryptocurrency Arbitrage

INTRODUCTION

Cryptocurrency arbitrage is a trading strategy whereby price discrepancies for the same token across different exchanges are taken advantage of. High volatility in cryptocurrency markets allows arbitrageurs to capitalize on unequal pricing mechanisms across the market. This could be as simple as buying a token worth $1 on Exchange A and selling it on Exchange B where it is valued at $1.05, to more complex flash loan arbitrages.

This article will explain how arbitrage works and discuss the various types which can be executed, as well as their associated risks.

SUMMARY

• Cryptocurrency arbitrage trading is a trading strategy whereby traders buy and sell a token on different exchanges to profit from the fact that the price of the same asset may be different across exchanges.
• Arbitrage using bots provides an automated and continuous method for arbitrageurs to profit from these opportunities. It is used by more technically savvy traders.
• Sudden market fluctuations, as well as fees, will affect the final net profit a trader can realize.
• Flash loan arbitrage is a more advanced crypto arbitrage method that requires an in-depth understanding of DeFi as well as advanced programming knowledge. It often makes use of large dollar amounts to execute the arbitrage transaction.

WHAT IS CRYPTOCURRENCY ARBITRAGE?

Cryptocurrency arbitrage is the process of buying and selling cryptocurrencies on different markets to take advantage of price variations. This trading strategy has long existed in traditional markets and is popular among both retail traders and trading firms.

As the market has grown more sophisticated, more technically proficient traders using bots, which can spot price differences and execute within mere milliseconds, have gained an advantage over human beings doing this manually. As such, many traders are required to use bots in their arbitrage trading to have any hope of competing.

WHAT IS ARBITRAGE?

Arbitrage is buying something in one market and immediately selling it in another market where, for whatever reason, the price is higher. For example, you might find a second hand luxury bag for $500 in a thrift store that is selling online for $600. If you buy the bag in the thrift store in order to sell it online for a $100 profit, that’s arbitrage.

Crypto traders do exactly this across different digital assets - and will find places where an asset is worth less than it is worth in another marketplace, and buy from the first and rapidly sell on the second to realize a profit.

Here’s an example:

1. Trader notices that ETH on BNB Chain is worth $2000, below than the price of ETH on a centralized exchange (CEX) - say $2100.
2. Trader buys 1 ETH on BNB Chain for $2000 (minus gas fees), sends this immediately to a CEX and sells it there for $2100 (minus CEX fees).
3. The price difference between ETH on BNB Chain and the CEX is profit to the trader ($100 - adjusted down for fees).
4. The trader repeats this process so long as the arbitrage opportunity remains valid - eventually, supply/demand would (in theory) cause the prices of ETH on BNB Chain and the CEX to converge.
   

THE DIFFERENT TYPES OF CRYPTO ARBITRAGE

In this section, we will look at some of the popular arbitrage methods that exist, as well as some of the advantages and disadvantages of each type. Note that this isn’t an exhaustive list of all arbitrage strategies that exist. The nature of arbitrage is that new opportunities frequently emerge and savvy traders take advantage of these strategies during a brief window in which they’re available before arbitrageurs or other market forces eliminate the opportunity.

FUNDING RATE ARBITRAGE

Funding rate arbitrage is most commonly practiced by traders using leverage. For instance, if a trader is longing the market using perpetual futures (expecting a price increase) or shorting the market (expecting a price decrease), the trader either pays a fee or receives a payment which is referred to as the “funding rate”.

Funding rates are used by exchanges to keep the price of a futures asset consistent with the actual asset’s price. If the futures price of BTC deviates from the spot price, the funding rate acts as an incentive for traders to enter the opposite side of the trade. By doing this, they earn a recurring payment - which encourages traders to arbitrage the price back to the spot level. If more people are shorting than longing, short traders pay the long traders and vice versa - this encourages traders to take the less popular trade.

When it comes to performing arbitrage on funding rates, a leveraged trader would hedge their long or short position with an opposite spot position, to benefit from the gains that arise from the funding rate. In brief, traders profit by borrowing funds in the spot market (at low-interest rates) and use these funds to open a leveraged position in the futures market where funding rates are higher. The difference in interest rates between the spot market and perpetual futures contract is referred to as funding rate arbitrage. Taking advantage of this difference is how funding rate arbitrageurs make money.

One of the main advantages of funding rate arbitrage is that traders can generate returns without much direct portfolio exposure to the market. A disadvantage is in the complexity of this strategy, which requires deep knowledge of the cryptocurrency market, trading mechanics and risk management methods.

FLASH LOAN ARBITRAGE

Flash loans are another prominent method of arbitrage - they refer to an instant loan without collateral, in which all of the trades take place in a single transaction. They’re a novel form of arbitrage used by advanced DeFi traders - and require traders to make and return a loan in a single block. 

This allows them to perform an arbitrage transaction with significantly more capital than they might otherwise have access to, as the transaction is hard coded to ensure that any funds that are used in the arbitrage are effectively returned right away. If the contract detects an error or that the loan cannot be paid back for some reason, the transaction automatically reverts.

To perform a flash loan arbitrage, a trader must have advanced crypto knowledge,  programming skills to set up the bot that will perform the flash loan, as well as a knowledge of smart contracts.

An example of how a flash loan works:

1. Trader connects to a DeFi platform of choice that offers flash loans (like MakerDAO).
2. The trader specifies the token to be borrowed and the amount.
3. The flash loan is executed. Money is borrowed and returned in one single transaction - conditional upon generating a positive profit from the arbitrage which can cover fees.

Flash loans are used for a range of purposes in DeFi arbitrage. An example would be a trader using a flash loan to take control of and liquidate a position on Aave. They’re also used by malicious actors to exploit smart contracts through actions like token issuance.

Flash loan arbitrageurs typically do not scan the blockchain or search for opportunities manually. These traders typically have an algorithm or “scraper” that scans the blockchain continuously to detect profitable arbitrage opportunities. When an interesting arbitrage opportunity is detected, another algorithm is triggered to run and perform the flash loan arbitrage trade. Such an arbitrage happens very rapidly, and the arbitrageur with the most effective and optimized code will often be the first to seize the opportunity.

Some arbitrageurs may be more cautious and perform a backtest before executing a profitable arbitrage opportunity they’ve discovered. The specific methods for executing flash loan arbitrage are as numerous as there are technically proficient traders with unique strategies. What all flash loans have in common is the mechanism of borrowing and returning capital in a single block - t.

One advantage of flash loan arbitrage is that there is no collateral required to take out the loan. Traders profit from temporary price discrepancies of a cryptocurrency without requiring significant capital up front; the arbitrageurs borrow large sums instantly (and return them instantly). On the other hand, flash loans require advanced programming and DeFi knowledge to execute successfully and aren’t really an option for the beginner. An arbitrageur may encounter technical issues or other complexities in smart contracts that require skills and experience to overcome.

CROSS-EXCHANGE ARBITRAGE

This refers to arbitrage strategies which make use of price differences for the same asset on different exchanges. It’s often done by algorithmic traders who use bots to take advantage of small discrepancies in prices across exchanges and execute arbitrage transactions in milliseconds. While a trader can try to do cross-exchange arbitrage manually, they are liable to be outcompeted by bots that move faster and eliminate the arbitrage opportunity before they are able to finish executing the trade.

Arbitrage bots are typically custom-built by traders who don’t share them with anyone else in order to maintain an edge. Using commercially available arbitrage bots is risky because they are sometimes sold by scammers who design them to drain user funds. They also may not be optimized for a particular market or trading strategy.

While cross-exchange arbitrage isn’t complicated in principle - one simply has to find price discrepancies, then buy and sell around them - the execution is tricky and finding opportunities which can be taken advantage of is the challenge for the arbitrageur.

P2P ARBITRAGE

P2P (peer-to-peer) arbitrage is a common practice in the developing world - it involves selling crypto to users without the ability or desire to access crypto on a CEX or other easily available source. The arbitrageur typically sells the desired token at a markup to a buyer, after acquiring these through some other method for a cheaper price.

This is often done in countries such as Lebanon and Turkey - and typically involves local resellers dealing directly with clients in person. However, certain exchanges also facilitate this process - and allow their clients to purchase tokens P2P and facilitate this through their platform at a pre-agreed price. It can also be done cross-border - users may simply agree to a price through a direct channel like X or Discord and then swap tokens for fiat directly or through an escrow.

This arbitrage method is often used with stablecoins, as the lower volatility gives the arbitrageur a clearer return profile - especially on larger volumes with repeat customers.

In some cases, especially during bull runs, it is not uncommon to see 10-30% premiums above spot on P2P exchanges. However, this does not come risk-free for both the arbitrageur and the buyer, as P2P arbitrage is often murky and reliant upon trust in the counterparty. Buyers often build a relationship with sellers in advance/over time to reduce this risk and work on the basis of referrals. There also may be security risks in the exchange of funds - insofar as the buyer or seller may expose themselves as a large holder of crypto or fiat, which could attract unwanted attention.

WHY DOES CRYPTO ARBITRAGE EXIST?

The same asset may be worth a different amount across different exchanges for many reasons:

1. Market Fluctuations: Crypto is highly volatile and as such, prices routinely differ across markets for the same asset on shorter timeframes - the differences in these prices are normal and incentivize traders to keep bringing these prices back to equilibrium through arbitrage, ensuring asset prices in different markets don’t deviate too far from one another. These fluctuations can be exacerbated during times of higher volatility e.g. BTC’s price rapidly rising or declining, or a stablecoin depegging.
   
   
2. Market Manipulation: In certain markets, traders with size (or malicious intent) can cause asset prices to deviate deliberately and seek to benefit from a discrepancy they’ve caused themselves.
   
   
3. Exchange Factors: If an exchange is hacked, or a large sale of tokens takes place, an asset price might deviate from that asset’s price on other exchanges. This provides a clear arbitrage setup which a trader (or malicious actor) may take advantage of.
   
   
4. Geographical Arbitrage: Regulation, timezone differences, local currency differences as well as local supply/demand imbalances can create arbitrage opportunities for traders. These are often more challenging to execute, as they require traders to operate across borders and deal with each jurisdiction’s trading laws.

ARBITRAGE CASE STUDY: THE KIMCHI PREMIUM

One example of an arbitrage opportunity which traders have taken advantage of is the Kimchi Premium. This refers to the BTC price trading higher on Korean exchanges than other ones, owing to the excess demand for BTC from traders. At times, this has even been a 50% premium over BTC’s price in non-Korean exchanges.

Traders have taken advantage of this by purchasing BTC on non-Korean exchanges and selling it on Korean exchanges, repeatedly. This can be challenging however, insofar as exchanging large amounts of Korean Won for non-crypto assets can be difficult, owing to capital controls on the Won.

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This has also been available in the Japanese market, where BTC has often been sold at a 10-15% premium. Traders buy BTC, send this to a Japanese exchange, & sell it on a Japanese one to take advantage of the premium. They could then exchange the other cryptocurrency/Yen to their preferred currency and send this back to themselves.

THE RISKS AND CHALLENGES OF ARBITRAGE TRADING

Crypto trading is generally higher-risk (see our article Crypto Trading 101: Risks),  but here are some of the risks associated with arbitrage trading in particular:

Terms of Use: Some exchanges forbid arbitrage strategies, whether manually or through bots.

Technical: Arbitrage bots require advanced programming skills to build & deploy, as well as extensive optimization to ensure they run successfully on their own. Once a bot is deployed, it needs to be maintained, tweaked & tested in a live environment to ensure it works as expected & delivers a return.

Fees: High fees can constantly rack up if trades are taken regularly or on certain chains like Ethereum - especially during periods of heightened market activity.

Volatility: During periods of high volatility, prices change faster and a poorly optimized bot may not be able to handle situations like this well. This is because rapid price changes can lead to bots not executing buys/sells quickly enough. CEXes may also experience unresponsiveness, lag or outages during these periods, further adding to the risk of bots not running properly.

Competition: Arbitrage traders must compete against other talented arbitrage traders seeking to exploit arbitrage opportunies as quickly as possible. This competition means that an arbitrage opportunity may disappear while a trader is in the process of taking advantage of it.

Capital: Because margins are usually small when running arbitrage strategies, traders generally require more capital under management to generate the necessary volume to make arbitrage trading worthwhile. 

Counterparty Risk: Arbitrage trades must be executed through a DeFi or CeFi trading platform - as such, the trader must place their trust in the forum on which they’re trading.

Bot Security: Bots are prone to being exploited or taken advantage of - additionally, developers might be able to insert a malicious backdoor into them.

CONCLUSION

Cryptocurrency arbitrage presents an opportunity for traders to gain from the price difference of the same token or coin across different marketplaces. However, successfully executing crypto arbitrage trades is extremely competitive and often requires advanced technical skills, a large amount of funds, and other special knowledge.

Next, read Arkham’s guide to trading for beginners.